This article is reprinted with permission from the
September 30, 1991
edition of

New York Law Journal.

1991 NLP IP Company.


Shadow Stock Plans

By Joseph E. Bachelder.


THIS COLUMN REPORTS on a recent Tax Court decision involving the issue of constructive receipt. It also discusses a form of insurance for the payment of deferred compensation offered by Lloyd's of London.

Constructive Receipt

In a recent decision, George C. Martin et al. v. Commissioner, 96 T.C. No. 39 (June 18, 1991), the Tax Court addressed the question whether two executives should be required to include in taxable income for the year of their termination of employment (1981) the full amounts to which they were entitled under a shadow stock plan. The Internal Revenue Service raised the issue notwithstanding the fact that the executives had elected before terminating employment to receive the amounts involved over 10 years and had no right after termination to revoke such election. The Tax Court concluded that the executives should be taxed in accordance with their elections and not in a lump sum in the year of their retirement.

As will be discussed further below, in Revenue Ruling 80-300, 1980-2 C.B. 165, the IRS held that the holder of a stock appreciation right (SAR) should not be taxed until exercise of the SAR. In view of the logic of that ruling (as well as Treasury Regulations, other rulings and tax cases including one in which, as noted below, the IRS has acquiesced), it is puzzling why the IRS decided to challenge the taxpayers in this case.

In the Martin case, the employer had in place for a number of years a program under which it granted share equivalents (units) to selected executives. A unit entitled the holder to the growth in value of a share of company stock between the date of grant and a subsequent date on which the share equivalent unit was valued for purposes of payout. For this purpose, value was defined, according to the court's findings, as consolidated net income or loss per common share for the period the unit was held less dividends per common share for the same period. Holders of units apparently participated, on a dividend-equivalent basis, in dividends declared during the period they held units. Individual awards were represented by a contract between the employer and the participant. There was no separate plan document.

Under this unit program, the employee had the right to surrender the units at any time (presumably only those that were vested) and receive payment of the then value, in which event the participant presumably would be giving up the opportunity to participate in future growth. Upon termination of employment, the participant would be entitled to payment of the then value of those units not previously surrendered and in which he was then vested. Upon a cashing out (whether in a voluntary surrender of units during employment or a surrender of units as required upon a termination of employment), the unit agreements provided that payment would be made in installments over 10 years without interest. There was no alternative form of payout.

In 1981 the employer made some changes in the program. These included the following:

* An overall plan was adopted and awards were made pursuant to that plan, rather than as previously provided through individual contracts. As an incident of the new program, the awards were called "shares of Shadow Stock" but the nature of the award remained essentially the same: the opportunity to share in the growth in value of the underlying stock and to receive dividend equivalent payments.

* The participants were given a choice between (i) a 10-year installment payout with interest (80 percent of the average prime rate as set by Morgan Guaranty for its customers for the year preceding the year of the interest payment) and (ii) a lump sum payment at the time of surrender of the shares of shadow stock.

The right of the executive to choose the 10-year installment payout had to be exercised before his surrender of the shares of shadow stock involved; otherwise payout would be in a lump sum.

Thus, in no event could the executive "cash out" the shares of shadow stock without relinquishing his right to future growth in value of those shares. This was true whether it was a voluntary surrender during employment (in which event the plan explicitly provided for cancellation of the shares of shadow stock surrendered) or a required surrender upon termination of employment (in which event the plan likewise provided there would be no further participation in growth of the shares). For purposes of the new plan, the definition of value of a share of shadow stock is virtually the same as described above in connection with units under the old plan. As noted, the holders of shadow stock also were entitled to dividend equivalents if dividends were declared during the period they held their shares of shadow stock.

Exchange of Units

Shortly after the new plan was adopted, the executives involved exchanged their units under the old program for the shares of shadow stock under the new program. One of the executives elected on May 7, 1981, one week after the adoption of the new plan, to receive payments in 10 annual installments. On Aug. 31, 1981, the executive voluntarily terminated employment and received the first installment in October 1981.

The other executive elected on July 16, 1981, to receive the payout in 10 annual installments. On Aug. 1, 1981, the employment of the second executive was involuntarily terminated. The court found that notice of the involuntary termination was given to the executive "approximately one week in advance of Aug. 1, 1981." Based on that finding, the executive's July 16 election occurred before the termination of employment and surrender of shares. This election was in accordance with the terms of the plan. Like the first executive, the second executive received the first installment in October 1981.

For a cash-basis taxpayer, the basic rule of tax accounting is that tax ordinarily is incurred at the time of receipt (rather than at the point of accrual as in the case of an accrual basis taxpayer). An exception to that rule applies in a case in which the income is available to the taxpayer who simply needs to give notice in order to have actual receipt. Put another way, if a payment is unconditionally available to a taxpayer, the taxpayer cannot defer taxability by simply "turning has back on it." The taxpayer is deemed to be in constructive receipt of the income.

In many cases the next question is whether a payment is currently available, without any real condition to its payment. Treasury Regulation 1.451-2(a) states this aspect of the rule as follows:

[Income] is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

Numerous Treasury Regulations and cases have addressed the question of what is a substantial limitation or restriction upon the receipt of income. In 1980 the IRS issued Revenue Ruling 80-300 in which it held that the holder of an SAR would not be taxed until exercise of the SAR. It explained its holding as follows:

The forfeiture of a valuable right is a substantial limitation that precludes constructive receipt of income. The employee's right to benefit from further appreciation of stock, in this case, without risking any capital is a valuable right. However, once the employee exercises the stock appreciation rights, the employee loses all chance of further appreciation with respect to that stock and the amount payable becomes fixed and available without limitation. Accordingly, an employee will be in receipt of income on the date the SAR's are exercised.

It is difficult to see how the circumstances in the Martin case are distinguishable from those in Revenue Ruling 80-300 for purposes of applying the constructive receipt rule. Up to the point of actual exercise or surrender of an SAR or shares of shadow stock, the holder is not subject to taxability. (For the purpose of this discussion there would not seem to be a meaningful distinction between an SAR and shares of shadow stock as described in the Martin case. The fact that the value of the SAR in Revenue Ruling 80-300 was determined by the public market for the stock whereas the value of the shares of shadow stock in Martin were determined by future earnings of the privately held employer should not, in the author's view, make a difference.) Accordingly, whatever choices the holder of shares of shadow stock may have that can be made prior to (and only prior to) surrender of the shares of shadow stock should not result in taxability.

Logic, Common Sense

In the author's view, the Martin case applies the logic of Revenue Ruling 80-300 to the period before the surrender and simple common sense to the point of surrender and the period after surrender.

(1) During the period before surrender of shares of shadow stock the holders were not taxable because receive payment of the value of the shares they had to forfeit a valuable right (that is, the right to share in future growth in value of the shares and to participate in any future dividends declared on company stock). During this period their right to choose the form of payment upon surrender did not affect the tax "shield" create by the substantial condition to receipt of the income -- the forfeiture of that valuable right to future income.

(2) At the point of surrender of the shares of shadow stock the holders became entitled to a payment, the form of which (lump sum or in installments) was fixed. They had no choice. Their choice had to be exercised before surrender. Put another way, once the tax "shield" represented by the required forfeiture of a valuable right disappeared as a result of surrender, so did the right of choice. Form of payment had become fixed.

(3) For the period following surrender the taxpayers had no rights in respect of the former shares other than the fixed right to payment (in this case, in 10 annual installments, with interest). In its findings of fact the Tax Court states "participants had no right to change any election of the form of payment after termination of employment. . . ."

As stated at the outset, the author is puzzled why the IRS, notwithstanding Revenue Ruling 80-300, chose to challenge the taxpayers in Martin. Also puzzling is the fact that no mention of Revenue Ruling 80-300 is made in the Tax Court's opinion. The court does, however, cite Hales v. Commissioner, 40 B.T.A. 1245 (1939), acq., 1940-41 C.B. 2, cited as one of its authorities by Revenue Ruling 80-300. Hales involved the issue of constructive receipt in circumstances in which the taxpayers could have received accumulated dividends by surrendering their stock, thereby forfeiting the right to participate in the future earnings of the business. The Board of Tax Appeals held there was no constructive receipt attributable to the right to surrender.

Deferred Compensation

As reported in a number of press accounts (see, article in Business Week, April 22, 1991, p. 114), "executive compensation indemnity" policies have been offered by Lloyd's of London. The basic concept is that Lloyd's will guarantee, for a period of years, deferred compensation (the one proposed policy reviewed by the author was for 10 years). The annual premium cost appears to be less than 1 percent of the amount covered. (The Business Week article indicates, as an example, 50 basis points, or 0.5 percent; it also indicates for a very highly rated company a premium as low as 30 basis points might be available.)

The obvious attraction of such a policy is the assurance it can give to an executive for the period covered by the policy that he will be paid the deferred compensation covered by the policy notwithstanding any future unwillingness or inability of the employer to pay during that period. From the employer's standpoint, it means giving that assurance without the heavier funding costs of, say, a trust.

One of the most serious drawbacks of such a policy is the uncertainty at this time as to how the IRS will treat an executive compensation indemnity policy. As recently as June, Thomas Brisendine, Branch Chief at the Office of the Assistant Chief Counsel, indicated that the IRS had not received any request for a ruling on such a policy. A concern expressed by Mr. Brisendine was that such a policy might be viewed as securing a promise to pay so as to result in taxability under 83 of the Internal Revenue Code of 1986 (Code). (In this connection, see the author's column entitled "Third Party Guarantees," New York Law Journal, July 30, 1990. Mr. Brisendine also raised questions whether such an arrangement might be deemed a funding arrangement for purposes of Title I of the Employee Retirement Income Security Act (ERISA). If so, it would require compliance with the funding and other requirements of that law.

Language in IRS rulings goes both ways on the question of whether an arrangement like that discussed should or should not cause current taxability of the deferred compensation. In support of non-taxability of the deferred compensation, see PLR 8406012; for dictum to the contrary, see PLR 8923020.

The Business Week article noted above indicates that for an additional premium equal to about 20 percent of the basic premium, Lloyd's would be willing to cover the executive, in addition, for any income tax triggered by the executive compensation indemnity policy. In this connection, the author reviewed such a policy with a rather troublesome clause in it that required the executive to agree not to report as taxable income any economic benefits attributable to the policy (other than actual payments, if any, received under the policy).

Notwithstanding its attractions, such a policy is unlikely to receive wide endorsement until and unless the IRS indicates that it will not treat such a policy as accelerating the deferred compensation insured by it. One suggestion made is that the executive pay the premium, presumably with an unwritten understanding that the employer will pay enough additional cash compensation so as to afford the executive the means (on an aftertax basis) to pay the premium. A coincidental "jump" in the executive's pay at the time such arrangement was entered into with the insurer presumably would be treated by the IRS as subject to the same treatment as would be applied if the employer paid the premium. (Without a coincidental "jump" in the executive's compensation, it would appear inconsistent with the position taken in PLR 8406012 for the IRS to assert that insurance paid for by the executive would accelerate taxability of the deferred amounts.)

In all events, a cautious approach in this area would seem appropriate pending clarification of the IRS position on taxability as well as clarification of the Department of Labor position on implications for purposes of Title I of ERISA.